Treasure Chest | Dec 20 2011
– Danske Bank assesses the currency market outlook for 2012
– Offers six main themes expected to drive markets
– 10 currency trading ideas are outlined
By Chris Shaw
With 2011 fast drawing to a close attention has turned to the coming year, with Danske Bank offering its top foreign exchange trading ideas for the year ahead. There are 10 trading ideas, centred around six main themes for the market.
These themes are: recession fears are currently excessive, global monetary easing will continue, the EMU crisis will continue but there will be no break-up of the euro, volatility on markets will remain high, the US dollar will face some structural headwinds and some currencies will see continued intervention efforts.
In general, Danske Bank has a non-bearish view on the market, this the third consecutive year of such a view. While not overly optimistic on growth or risk appetite given the sovereign debt crisis and the eurozone in recession, an overly negative economic and financial outlook appears to be priced into financial markets at present.
Danske Bank suggests the current environment has some similarities to early in 2009, when the market also feared a severe economic recession that subsequently never emerged. Having said that, the top trading ideas for 2012 include some strategies that adopt a more cautious view, as the past couple of years have taught the importance of guarding against tail-risk events.
With respect to the excessive recession fear theme, Danske Bank notes while the OECD composite leading indicator framework implies the global economy is in a slowdown phase, it is no certainty the existing environment will continue to weigh on risk assets.
This is because markets have already discounted a European recession and weak global growth, as market positioning is stretched and investors are underweight risk. This means it may only take some stabilisation in macro data to trigger a relief rally in risk assets. This is just what Danske Bank is forecasting.
The coming year is unlikely to prove as positive for risk assets as 2009 and 2010, but Danske Bank sees scope for a stabilising in data to provide moderate support to both risk assets and also forex carry strategies. Cyclical currencies supported by the strongest fundamentals should also see some support.
Going into 2012 it is widely expected there will be additional monetary easing around the globe, the question being who undertakes such action. Given decent growth expectations next year the US is unlikely to loosen policy further, but Danske Bank expects the Bank of England will continue with its current quantitative easing policy. The Swiss National Bank may look to lift the floor against the euro, while there is scope for the Japanese to put a floor under USD/JPY.
Recent central bank actions to cut funding costs show these banks are not out of ammunition and Danske Bank notes some new monetary policies are being considered. Policy is likely to be more innovative next year, offering significant event risk in forex markets.
As the eurozone debt crisis has deepened, politicians have failed to deliver a convincing and sustainable solution, which to Danske Bank suggests the crisis will remain an important theme through 2012. The crisis is likely to see the European Central Bank take a more active role in the coming year, with a broader mandate expected.
In Danske Bank's view, the economic and financial impact of a euro break-up would be worse than the Lehman Brothers collapse, as a global recession would be highly likely. So while the euro may split, an exit would be very risky and potentially costly for any country. Tail risks from the European problems should stay with the market through the coming year, something Danske Bank sees as a barrier to risk asset upside.
2011 saw relatively modest changes in implied and realised volatility, this despite financial markets being hit by multiple shocks. In 2012 Danske Bank expects the tug-of-war between slowly improving global macro data and high event risk will generate significant overall swings in the level of forex volatility.
Base volatility should also remain high as euro debt concerns will remain in focus through the year, so Danske Bank doesn't expect a correction in the current directional bias priced in on option markets.
In the absence of a global recession and a euro tail-risk event Danske Bank expects the US dollar will weaken in 2012, though by a relatively modest amount. This reflects the view still weak US fundamentals will drive a US dollar depreciation trend.
This is most likely to be evident against the strongest currencies such as the Canadian and Australian dollars, Danske Bank suggesting US dollar moves against the euro are tougher to predict given Europe's existing issues.
Entering 2012 with capital flows seeking safer destinations given bouts of risk aversion, Danske Bank suggests the interventionist dynamics seen in the second half of this year are likely to continue. This suggests some value in long volatility exposure.
The top forex strategies of Danske Bank reflect these themes and offer a number of alternative plays in the market. One is selling EUR/SEK strangle to take advantage of an upfront premium of 2,660 SEK pips. The trade reflects Danske Bank's view slower global growth will weight on the Swedish currency, even though foreign demand for high quality Swedish assets remains intact.
A second strategy offered by Danske Bank is the Swiss deflation trade, which involves buying EUR/CHF in expectation of further easing in monetary policy by the Swiss National Bank. This is most likely to take the form of a higher floor for the EUR/CHF than is currently in place.
Looking at 2012, Danske Bank sees the year as one where the NOK/SEK breaks out of its stable trading range, though the direction of any breakout remains unclear. This means while the business cycle and monetary policies in place in Norway and Sweden imply a higher NOK/SEK, Danske Bank sees the risk of an unexpected outcome as well. To play the breakout the bank suggests a six-month butterfly strategy.
Strategy four is based on the view China avoids a hard economic landing, which implies further gains for the Chinese currency against the US dollar even if the pace of appreciation slows. Danske Bank sees little downside to being positioned for further gains in the Chinese currency, as any policy response to slowing growth in China should not impact the currency against the greenback.
For the USD/JPY Danske Bank expects range trading through the first half of 2012, the downside supported by potential Bank of Japan intervention and the upside limited by sluggish global growth. Given such expectations, Danske Bank's approach is to buy a put butterfly spread, that should profit if the currency pair doesn't move significantly in either direction.
A sixth strategy offered by Danske Bank involves buying a one-year EUR/TRY out-of-the-money put option, which reflects the potential for the Turkish currency to rally against the euro as the economy re-balances in 2012. The Turkish lira is now close to fundamental fair value against the euro but is supported by a hefty carry and a hawkish bias on the part of the Turkish central bank, with implies some appreciation potential in the medium-term.
Norway's economy appears in good shape relative to the US and the eurozone, which to Danske Bank implies potential for further appreciation in coming months. To play this, the strategy suggestion is to sell both 12-month EUR/NOK and 12-month USD/NOK forwards, which would lock in the carry today and deliver gains if the expected scenario of a strong Norwegian economy plays out.
The eurozone crisis has seen the GDP/PLN pair rise by more than 20% in the second half of this year and with Poland expected to outperform the UK on almost all fronts in 2012 as well, Danske Bank sees gains to be made from selling GBP/PLN at spot.
A repricing of global recession fears is expected to push USD/CAD lower in 2012, Danske Bank seeing the Canadian dollar as a beneficiary of a recovery in the US economy and higher oil prices. With the currency pair closely correlated with risk, a better risk appetite could push the pair significantly. This leads Danske Bank to recommend selling the USD/CAD spot at 1.034, with a target of 0.9640.
An expected unwinding of stretched risk-off positions should support moderate forex carry strategies in 2012 in Danske Bank's view, though a weak macro backdrop means giving up part of a potential carry pickup to gain exposure to currencies backed by stronger fundamentals is recommended.
Danske's approach is to buy an equally weighted basket of Australian Dollar, Singapore Dollar and the Mexican peso against a short US dollar position. The strategy is expected to yield an annualised carry of 2.0% and lowers downside risks associated with standard carry maximising strategies as the currency selection is subject to macroeconomic criteria.
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